Underwriting versus Economy: A New Approach to Decomposing Mortgage Losses

Ashish Das and Roger M Stein

Contents

Introduction to 'Lessons from the Financial Crisis'

1.

The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can be Learned?

2.

Underwriting versus Economy: A New Approach to Decomposing Mortgage Losses

3.

The Shadow Banking System and Hyman Minsky’s Economic Journey

4.

The Collapse of the Icelandic Banking System

5.

The Quant Crunch Experience and the Future of Quantitative Investing

6.

No Margin for Error: The Impact of the Credit Crisis on Derivatives Markets

7.

The Re-Emergence of Distressed Exchanges in Corporate Restructurings

8.

Modelling Systemic and Sovereign Risks

9.

Measuring and Managing Risk in Innovative Financial Instruments

10.

Forecasting Extreme Risk of Equity Portfolios with Fundamental Factors

11.

Limits of Implied Credit Correlation Metrics Before and During the Crisis

12.

Another view on the pricing of MBSs, CMOs and CDOs of ABS

13.

Pricing of Credit Derivatives with and without Counterparty and Collateral Adjustments

14.

A Practical Guide to Monte Carlo CVA

15.

The Endogenous Dynamics of Markets: Price Impact, Feedback Loops and Instabilities

16.

Market Panics: Correlation Dynamics, Dispersion and Tails

17.

Financial Complexity and Systemic Stability in Trading Markets

18.

The Martingale Theory of Bubbles: Implications for the Valuation of Derivatives and Detecting Bubbles

19.

Managing through a Crisis: Practical Insights and Lessons Learned for Quantitatively Managed Equity Portfolios

20.

Active Risk Management: A Credit Investor’s Perspective

21.

Investment Strategy Returns: Volatility, Asymmetry, Fat Tails and the Nature of Alpha

Recent events in the mortgage market have led market participants and observers to discuss the role of underwriting standards in the 2007–9 market crisis. This chapter presents some stylised facts based on a series of ex post simulation experiments that were conducted using loan-by-loan data on 136 subprime mortgage pools underlying US residential mortgage-backed securities (RMBSs) issued between 2002 and 2007. The goal of these experiments is to provide some sense of the degree to which shifts in underwriting standards and the changing economic environment affect subsequent pool performance. In order to accomplish this decomposition, an instrument based on the transformation of a readily available Federal Reserve (hereafter simply referred to as “Fed”) series is used that exogenises underwriting explicitly. This exogeneity is particularly convenient in settings where underwriting standards and the future state of the economy are evolving in tandem, as it permits a separation of these two effects. An attractive feature of this measure is that it can be observed in real time, and thus may be useful for forecasting subsequent mortgage performance for newly originated mortgages before

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